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Saturday, February 13, 2016

Everyone knows the gap between rich and poor has been widening in most developed countries, but why is it happening? Have the rich been smarter and harder working, or have they just been craftier than the rest of us?

Between the end of World War II and sometime in the 1970s or '80s, the gap got progressively narrower, reducing inequality. Since then, however, the trend has reversed and the rich have got richer faster than the poor have got less poor.

That's particularly true for the English-speaking rich countries, though it hasn't happened as much in Oz as it has in Britain and, especially, the United States.

Here, real incomes have increased at the bottom, the middle and the top, though they've risen a lot faster at the top. And the respective shares haven't changed much in very recent years.

It remains true, however, that Australia's been part of the international trend to exceptionally strong growth in incomes right at the top of the distribution, say, the top 1 per cent.

In Australia's case, Professor Paul Frijters, of the University of Queensland, and Dr Gigi Foster, of the University of NSW, sought to explain this growth in top incomes in a paper published in the Australian Economic Review.

At the level of theorising, they say there are two rival potential explanations: that incomes have become more unequal as a byproduct of market forces, or as a result of political decisions.

The first explanation focuses on a shift in the "marginal productivity" of skills. Changes in technology – the obvious candidate being the information and communication revolution, aka computerisation and digitisation – have increased the value of certain highly skilled jobs relative to other, less skilled, more routine jobs.

This economists refer to as "skill-biased technological change". Some jobs are replaced by machines, others are in greater demand because of the need for people to control and maintain the new machines and to manage a more complex organisation.

In such a world, you'd expect the wealthiest people in the community to be highly technically trained and great organisers – people like Bill Gates and Warren Buffett.

A related phenomenon is what the authors call "increasing returns to superstars", but is otherwise known as the rise of "winner-takes-all" markets.

Legal and sporting contests, for example, reward people not so much because they're highly skilled but because they're more highly skilled than others.

Such rewards increase with the size of the market in which the contest occurs.

"Moving from a world where every town runs its own competition to one where a single high-stakes competition is held for a whole country, or the whole world, involves the replacement of local winners with uber-winners who enjoy far higher returns but of whom there are far fewer per type of contest, resulting in a more unequal overall income distribution," Frijters and Foster say.

"This kind of effect explains the enormous salaries earned by today's soccer stars, top artists, top financial advisers, inventors who obtain patents, and so on."

It's advances in communication technology that do most to explain the increased scale of many markets. Bigger scale means a bigger gap between people at the top of the world market and winners in the local market.

The returns to innovation are also much greater in a global market than in a local one, because you're pushing out for the whole world what economists call the "production possibility frontier" – increasing the menu of different goods and services we're able to produce.

The alternative explanation for growing inequality – especially at the very top – is the effect of political favours.

"Our democratic political process both sets the rules of economic interaction amongst market agents [participants] and allocates political favours, including taxes and subsidies. In this view, each institution within a country's bureaucracy has some discretionary power of its own," the authors say.

The political balance of power may change and lead to changed taxes and transfer (welfare) payments in ways that favour the rich and hurt the poor. This may happen by accident or by political design.
It may happen because interest groups become more effective at lobbying governments or because the rich become better at exploiting loopholes in regulations or taxes.

So much for theoretical possibilities. What hard evidence can we find to help us choose between those possibilities?

A study by Sir Anthony Atkinson, a British world expert on inequality, and Andrew Leigh, former economics professor and now federal Labor politician, found that reductions in tax rates explain between a third and half of the rise in the income share of the richest 1 per cent in five English-speaking countries.

But Frijters and Foster took the unusual approach of seeing what clues they could deduce from studying the BRW magazine's list of the richest 200 Australians in 2009. They found that the industry category producing the largest number of super-rich Aussies – 61 – was buying and selling property.

Natural resources was second with 23, then "organising financial investments" with 19. "These 103 cases account for the vast bulk of the $119 billion owned by the top 200 in 2009."

Only eight families in the top 200 held large amounts of inherited wealth and all eight were in those three industry categories. So most of the money of our super-rich was made relatively recently.

As best the authors could determine, only five people on the list invented things. Another five were top entertainers. So only 5 per cent of our super-rich could be classed as superstars or top innovators.

About half spent their efforts on activities where local political decisions determine the winners: about who gets to build which property where, who gets access to favourable mining concessions, and so on.

On the basis of this evidence – which is hardly definitive – the authors conclude that "the political favours story seems more likely than the marginal productivity story".